CAIR/CARTAC/World Bank Workshop and Conference Rose Hall Resort and Spa, 1-5 December 2008 Accounting for Insurance Contracts The Long Winding Road 5 December 2008 Alok Jain

1 PRESENTATION STRUCTURE  Objectives and overview of IFRS 4 (Phase I)  Phase II – IASB Discussion Paper  Comments and Key Contentious Areas  A High Level Comparison with Solvency II  Practical Implications This presentation is structured as follows:

2 IFRS 4 – PHASE I  Interim standard - focused primarily on disclosures and classification of insurance contracts.  Introduced a definition for an insurance contract based on the contract containing significant insurance risk.  Required only limited changes to existing accounting practices for insurance contracts and extensive disclosures.  Elimination of equalisation and catastrophe reserves utilized in some countries. A principles-based framework that allows a high degree of discretion.

3 IFRS 4 – PHASE I – KEY PROBLEMS  The key achievement of IFRS 4 (Phase I) was a standard definition of insurance contracts. It did not prescribe accounting for insurance contracts; hence, there is great diversity in insurance accounting among jurisdictions  Accounting mismatch between assets (which are reported at fair value) and liabilities (which are not)  No consistency or transparency in the level of conservatism in estimates - Phase I merely prohibited further increasing the level of conservatism in reserving, but did not require that a “best estimate” approach

4 INSURANCE ACCOUNTING – ANALYSTS’ COMMENTS Between May and October 2007, PricewaterhouseCoopers carried out in-depth interviews with 39 dedicated insurance analysts from the US, Europe, Asia and Australia. ‘As it stands, financial reporting for life insurance companies is not useful to investors. The fundamentals of the business are not visible. Analysts cannot do any basic analysis and they have to resort to alternative bases.’ ‘Non-life business is not transparent because companies manage the level of reserves as the cycle swings up and down.’

5 PHASE II – STATUS OF THE PROJECT Phase II work begun - Jul 04 Discussion Paper published - May 07 Comment period ends - Nov 07 Phase II Draft IFRS published – Late 09? Phase II IFRS published – Late 2010? Phase II IFRS effective 2012? We are here  Current situation for accounting for insurance contracts is a mixed model  Resulted in too much diversity, less relevance and reliability, and inconsistency  The IASB started with a clean slate to develop Phase II  Modified joint project with FASB (US GAAP convergence)

6 IASB DISCUSSION PAPER  Published on 3 May 2007  149 pages plus 83 pages of appendices  21 specific questions for comment by 16 November 2007  161 responses received from individuals, life and non-life companies, industry groups, accounting and actuarial firms, analysts, and regulators.  Responses came from all parts of the world underlining the global nature of the debate IASB Discussion Paper “Preliminary Views on Insurance Contracts”

7 SCOPE OF THE DISCUSSION PAPER

8 ACCOUNTING MODEL Single accounting model Discounting for non-life business Strong opposition from US industry Exit value model Controversial (inside and outside IASB) Day one gains Entry vs. Exit Value Illustration: 10 year single premium policy sold by insurer X for $1,000 Expected to realise a profit for insurer X of $250 on average Insurer Y prepared to purchase policy from X for $900 (after allowing for risk) Entry value liability = $1,000 Initial profit is $nil Exit value liability = $900 Initial profit is $100

9 THE MODEL AT A GLANCE Life of the contract Claims Receive premiums to stand ready Stand ready to pay claims Probability weighted Probability weighted The contract can be an asset or liability

10 CURRENT EXIT VALUE MODEL The amount the insurer would expect to pay to another entity if it transferred all its remaining obligations and contractual rights to that entity Time value of money Discount rate Current unbiased probability weighted estimates of future cash flows Current estimates Risk Margin Service Margin Margins The Three Building Blocks

11 ESTIMATES OF FUTURE CONTRACTUAL CASH FLOWS  Explicit  Unbiased  Market-consistent  Probability-weighted  Current  Exclude entity specific

12 WHICH CASH FLOWS? INCLUDE Policyholder claims Claims handling and maintenance expenses Direct and indirect costs of benefits in kind Option and guarantees Unfavourable policyholder behaviour EXCLUDE  Investment returns  Reinsurance  Income tax  Entity specific  Non-guaranteed insurability premiums

13 DISCOUNT RATES “Consistent with observable current market prices for cash flows whose characteristics match those of the insurance liability, in terms of, for example, timing, currency and liquidity” Own Credit Characteristics

14 HOW TO CALCULATE THE RISK MARGIN No prescribed technique Compensation for bearing risk Reference to what a market participant would require Not a ‘Shock-absorber” Unit of account is the portfolio

15 THE SERVICE MARGIN  Compensation for providing other services  Investment management services  What else?  Based on market price demanded by another party to assume the service obligation  Different from IAS 18  Could have day one profit or loss  Stage of completion is not the only driver to revenue - reference to market prices must be taken into account

16 THE SERVICE MARGIN Day One Loss No Day One Gain/Loss Day One Gain If margins are higher or lower than those required by market participants? =

17 PARTICIPATING CONTRACTS  Is there a present obligation?  IAS 37  Legal obligation  Constructive obligation  IASB’s view: Participating rights only create a liability when the insurer has an unconditional requirement to provide economic benefits

18 UNBUNDLING Interdependent resulting in arbitrary measurement Interdependent but not resulting in arbitrary measurement Not interdependent Phase II for whole contract Phase II for whole contract, but IAS 39 for deposit IAS 39 for deposit, Phase II for insurance

19 COMMENTS ON DP - KEY CONTENTIOUS AREAS  Day One profit is unpopular – “nothing is earned yet”  Opposition to “current exit value” as it:  Has questionable relevance as insurers generally expect to settle the liabilities by paying benefits rather than transferring to a third party  Excludes entity-specific cash flows  Greater clarity required around the nature of and basis for calculation of risk and service margins  Use of a discount rate reflecting characteristics of the liability (including own credit rating) rather than an asset-based rate  Use of discounting and risk margins for non-life insurance contracts

20 COMMENTS ON DP - KEY CONTENTIOUS AREAS  The IAS 37 Liabilities Project may narrow the definition of a constructive obligation and therefore limit the ability to recognise all expected payments to participating contract policyholders

21 INTERACTION WITH EU SOLVENCY II  EU insurance companies are preparing for Solvency II with implementation due by 2012  Solvency II rules for valuation of assets and liabilities are expected to be compatible with IFRS Phase II  While Solvency II is a European initiative, it is likely that other regulators globally will adopt solvency regimes with varying degrees of similarity to Solvency II  The timings and underlying principles of Solvency II and IFRS Phase II are moving ever closer, opening up valuable opportunities for synergies in systems, organisation and market communications.

22 COMPARISON WITH SOLVENCY II INCLUDE Differences from Solvency II  Definition of insurance contract  Profit / service margins  Customer relationship asset / future premiums  Own credit standing  Categories of assets and liabilities  Audit materiality versus relevance to supervisor  Segmentation analysis  Best estimate  Discounted  Risk margin  Transparency  Qualitative as well as quantitative  Risk management focus  Sensitivity testing Similarities with Solvency II Technical Disclosure

23 PRACTICAL IMPLICATIONS – FINANCIAL REPORTING Earnings volatility Revaluing insurance liabilities will create potential earnings volatility Potential day one profit or loss Using current exit values could lead to reported profit or loss at contract inception Impact on revenue The question of whether certain premiums should be treated as income or deposits is left open and could affect “top line” revenue Impact on equity Discretionary policy dividends qualify as liabilities only if there is a ‘constructive obligation’ to pay them

24 PRACTICAL IMPLICATIONS – OPERATIONAL Systems impact Forecasting future cash flows based on probability-weighted scenarios will require significant upgrade of modelling capabilities Organisational impact Use of risk margins and cash flow analyses in accounting will require closer integration among finance, regulatory, actuarial and risk management functions. Resource impact Need for more qualified actuarial as well as finance and IT personnel

25 Questions?